Cryptocurrencies are expanding into other facets of finance. The capital markets and trading businesses may soon see the entry of cryptocurrencies facilitating trading transactions across multiple asset classes, which will offer the benefits of minimal transaction costs, and secure and instant transfers. (For more, see: The Future Of Cryptocurrency.)

The leading investment bank, Goldman Sachs Group Inc. (GS), filed for a patent for its cryptocurrency in 2014, which was made public last month by the U.S. Patent and Trademark Office. GS is expected to launch its own cryptocurrency called SETLcoin, which will be used for trade settlement. Built around SETLcoin will be a robust trading system, which will offer instant trade settlements (against present day T+1 to T+3), a self-regulatory mechanism based on blockchain technology, and many other benefits which will make the functions of clearing houses redundant. (For more, see: What do T+1, T+2 and T+3 mean?)

Here's a sneak peek into how the SETLcoin based trading and settlement system will work.

Present Day Settlement System

After a trade is made between a buyer and a seller, the clearing house like the National Securities Clearing Corporation (NSCC) matches the trade instructions as received from both the trading parties. This process of matching is called clearing.

Following the successful matching of the trade details, the clearing house initiates the settlement process which involves the transfer of securities from the seller’s dematerialized (demat) account to the buyer’s demat account, and payment of money from buyer’s account to seller’s account. These processes of clearing and settlement can take from one to three business days, depending on the type of security traded.

This lag from the time of trade to the time of final settlement involves risks. For instance, one of the parties can default on providing securities (or payment money) which constitutes counterparty risk. The clearing house acts as a counterparty for the buyer and seller, and protects each from counterparty risk, thereby becoming a necessary party in present day trading business.

The cryptocurrency based system proposed by GS aims to replace the functions of a clearing house by offering instant, accurate and secure settlement of security as well as cash.

The Cryptocurrency Based Settlement System

First, let’s break down a basic example of a cryptocurrency transaction (like bitcoin). Assume Bob wants to send X bitcoins to Sam. Bob issues the necessary instructions to his bitcoin software to make the transfer from his bitcoin wallet to Sam’s, which in turn generates a transaction, which gets broadcasted to the Bitcoin network. The network involves a blockchain ledger which records every transaction occurring on the network. Once the transaction is recorded and verified on the network, the X bitcoins are debited from Bob’s wallet and credited to Sam’s wallet. (For more, see: What Does a Blockchain Record in a Bitcoin Exchange Transaction?)

Under the cryptocurrency based settlement system, GS will introduce a new cryptocurrency called SETLcoin. This cryptocurrency will be similar to the popular bitcoin digital currency, and will represent securities and other assets (including other cryptocurrencies). The underlying system will be based on blockchain, which will host virtual multi-asset wallet to store different kinds of securities (like stocks or bonds), cash, and cash equivalents in terms of SETLcoin.

How SETLCoin Based Trading Will Work?

SETLCoin is an expanded form of any popular digital currency (like bitcoin). In addition to facilitating cash equivalent transactions, it will also account for transacting in assets like stocks and bonds.

Let’s gain a better understanding of how this works with an example.

Bob, the stock buyer, will enter his buy side trade details in his digital wallet, and Sam, the stock seller, will enter his sell side trade details in his wallet. The instructions from their individual wallets (SETLcoin cryptocurrency software) will generate SETLcoin transactions, which will reach the blockchain based secure network. Once on the network, they will get authenticated and matched (clearing process), and the transfer of securities and money (settlement process) will occur instantly.

If Bob has sufficient funds to buy the shares, Sam holds a sufficient number of shares, and both have entered the trade details in their wallets correctly which are successfully matched by the blockchain network, the trade will get executed. Bob will now have the shares in his SETLcoin wallet, while Sam will have the funds in his SETLcoin wallet, and the trade transactions will get recorded on the blockchain.

A trader’s wallet can hold multiple securities in the form of SETLcoins. For instance, IBM and Apple shares may be represented as “IBM-S” SETLcoins and “AAPL-S” SETLcoins, respectively. IBM bonds may be represented as “IBM-B” SETLcoins, and USD currency as “USD” SETLcoins.

One IBM-S SETLcoin may represent 100 shares of IBM, while one AAPL-S SETLcoin may represent 5 shares of Apple. It will be possible to trade/exchange 5 IBM-S SETLcoins for 1 AAPL-S SETLcoin, or for 100 IBM-B SETLcoins, or for 1800 USD SETLcoins.

Essentially, the system allows seamless integration, facilitating multi-asset transactions.

The reliable blockchain technology with efficient self-regulatory mechanism will ensure instant and flawless execution of trades. (For more, see: What Is the Blockchain? - Video)

With the role of clearing house becoming redundant and getting replaced by network based automated ledger, the cost of trading is expected to come down substantially with the use of such systems. The recording of all transactions related to trading, clearing, settlement, demat accounts, and payment accounts getting moved to blockchain will result in a single platform with unified processing. It will lead to a significant decline in cost towards maintenance and transactions, with the reliable security and robust authentication of blockchain technology.

There have been long-standing concerns with regards to no regulation and borderless transactions being facilitated through blockchain technology and cryptocurrencies. The entry of dedicated systems being built by reputed organizations will allay those fears and mitigate the risks of unfair use.

The Bottom Line

The humongous growth of blockchain based cryptocurrencies have created a parallel universe of a large global economy, which is outside the purview of any regulators. With leading investment banks like GS and JP Morgan adapting to the concept and building financial systems based on blockchain, this path breaking technology is expected to become the future backbone of financial system. The SETLcoin is just the start, and there’s more to follow. (For more, see: JP Morgan's Blockchain Trial Project)

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.